The 2016 Election: The Pitfalls of Market Timing

Despite a tumultuous political environment, patient investors were rewarded in 2016 with healthy stock market gains in numerous asset classes. The S&P 500 Index of large U.S. stocks turned in a 12.0% return for the year, its eighth consecutive year of positive returns. Small U.S. stocks climbed even higher, with the Russell 2000 index up 8.8% for the quarter and 21.3% for the year. Other areas of the global stock market - foreign stocks and real estate securities in particular - booked more modest gains. For the fourth year in a row, U.S. stocks outperformed those of developed foreign markets. Bonds lost ground in the fourth quarter as interest rates surged, but still eked out a 2.1% gain for the year.

Asset class returns for the quarter and the full year were as follows:

Index

Asset Class

Fourth

Quarter 2016

Full Year

2016

Barclays U.S. Government/Credit Bond Index Intermediate

Fixed Income

-2.1%

2.1%

S&P 500

Large U.S. Stock

3.8%

12.0%

Russell 2000

Small U.S. Stock

8.8%

21.3%

MSCI ACWI ex-USA

Foreign Stock

-1.3%

4.5%

S&P Global REIT

Real Estate Securities

-5.1%

5.8%

Dominating the headlines in the fourth quarter were the widely-followed presidential campaigns of Hillary Clinton and Donald Trump and their clash of ideas and policy proposals. After many months of debates and controversy, we will have a new president in the White House on January 20, 2017. Many media pundits were quick to warn of a negative stock market reaction to an upset victory. Leading up to the election, the S&P 500 index fell for nine consecutive days - the longest consecutive losing streak in over 35 years. On the night of the election, as the winner was announced, futures contracts on the Dow Jones Industrial Average implied a drop of about 800 points. However, when the U.S. stock market opened the next day, the stock market was flat, and went on to notch a 1.1% gain for the day. Interestingly, this marked the first time in decades that the stock market closed higher the day after a new president was elected, and the U.S. market continued to climb for about a month after the election.

Election Winner

Election Day

Change in the S&P 500 the Day After the Election

Barack Obama (D)

11/4/2008

-5.27%

Harry S. Truman (D)

11/2/1948

-4.61%

Franklin D. Roosevelt (D)

11/8/1932

-4.42%

Franklin D. Roosevelt (D)

11/5/1940

-3.32%

Barack Obama (D)

11/6/2012

-2.37%

George W. Bush (R)

11/7/2000

-1.58%

Jimmy Carter (D)

11/2/1976

-1.14%

Dwight D. Eisenhower (R)

11/6/1956

-1.03%

Ronald Reagan (R)

11/6/1984

-0.73%

William Clinton (D)

11/3/1992

-0.67%

Donald Trump (R)

11/8/2016

1.11%

Source: Dow Jones/Yahoo! Finance

The media pundits were proven wrong in the aftermath of the election, as the predicted market decline did not materialize. The stock market’s positive reaction to the election is not out of the ordinary and is not necessarily surprising in light of efficient market theory. The Efficient Market Hypothesis (EMH), first proposed by Nobel Prize winner Eugene Fama, states that stock and bond prices reflect all available information at any point in time - and new information (e.g., the outcome of a presidential election) is very rapidly incorporated into market prices. New information about the outcome of the election was quickly priced into aggregate market prices by the buying and selling of stocks, consistent with efficient market theory.

Specifically, U.S. stocks were “re-priced” by market participants who foresaw a new political and economic environment characterized by lower corporate and individual tax rates and less regulation. Those who attempted to “time the market” by selling portions of their stock portfolio prior to the election were likely left on the sidelines as the market moved upward post-election. Of course, we do not know what the future will hold, and we do not claim to know where the market or economy will go from here. But, this election season provided a valuable lesson in the potential pitfalls of trying to outguess the stock market.

Major tax reform in 2017?

With Republicans primed to control the White House as well as both houses of Congress, momentum is certainly building for tax reform in 2017. Dowling & Yahnke has reviewed the current President-elect/House GOP proposals and will take this opportunity to highlight some of the potential changes and their ramifications. Please bear in mind that these are still proposals, and there remains a fair amount of dissent, even within the Republican Party, as to the specific priorities of a tax reform package.

The number of income tax brackets may be reduced. There are currently seven income tax brackets in the U.S. tax system (10%, 15%, 25%, 28%, 33%, 35%, and 39.6%). The President-elect and the House GOP have proposed simplifying to just three brackets (12%, 25%, and 33%). The House GOP has not, however, outlined where the income thresholds might fall for each new bracket.

Standard deductions and personal exemptions would be consolidated, while itemized deductions would be eliminated or capped. While some taxpayers may fall into a higher tax bracket under the new condensed brackets, the President-elect’s plan is to raise the standard deduction to $30,000 for a married couple (up from $12,600) and $15,000 for single filers (up from $6,300). This would give those who do not itemize their deductions a significant boost. However, the per-person exemption (currently $4,050) may be eliminated entirely, which could potentially hurt larger families. In addition, there may be a cap on itemized deductions ($200,000 for married couples and $100,000 for single filers). The House GOP has a drastically different proposal in which all but the mortgage interest and charitable gifting deductions would be eliminated. Like the President-elect’s proposal, the House GOP proposal would combine the standard deduction and personal exemption into one, but with lower amounts than the President-elect’s plan: $12,000 for individuals and $24,000 for married couples.

Estate taxes may be repealed. The new presidential administration has proposed repealing the estate tax entirely and replacing it with a capital gains tax (when assets are sold) on the amount of the estate over $10,000,000. Currently, the estate tax only affects those with estates over the estate tax exemption amount, which is $5,490,000 for single people and $10,980,000 for married couples. The House GOP has also vowed to repeal estate taxes, but the details have not been specified regarding any type of replacement tax.

The corporate tax rate may become more competitive with other countries. Currently, the U.S. has the third-highest marginal corporate tax rate in the world. In an effort to make American businesses more globally competitive, the current proposals would lower the corporate tax rate from 35% to 15% (President-elect) or 20% (House GOP), bringing the rate more in-line with the worldwide average of 22.5%. The House GOP has also proposed a maximum 25% tax rate for small businesses organized as sole proprietorships or pass-through entities.

Corporate profits may be repatriated. Under the new administration’s plan, corporations holding profits offshore would be able to bring those profits back to the U.S. for a one-time tax of 10%. Companies like Apple, Microsoft, General Electric, Pfizer, and IBM have a combined $400+ billion in cash parked overseas, so a considerable amount of cash and tax revenue could return to the U.S. if this proposal is enacted.

The 3.8% Medicare surtax on net investment income and the Alternative Minimum Tax (AMT) may be eliminated. This is included in both proposals.

Taxes on capital gains and investment income. Under the new administration’s proposal, the long-term capital gains tax (currently 0%, 15% or 20%, depending on the income tax bracket) would stay in place and would correspond directly to the proposed three-bracket system (i.e., those in the new 12% income tax bracket would pay 0%; those in the 25% income tax bracket would pay 15%; and those in the 33% income tax bracket would pay 20%). Under the House GOP proposal, the current long-term capital gains rates would be repealed and individuals would be able to exclude up to 50% of investment income (capital gains, qualified dividends, and interest income) with the remainder taxed at the new ordinary income tax rates - essentially giving way to rates of 6%, 12.5%, and 16.5% on investment income, depending on the taxpayer’s income tax bracket.

Minimizing income taxes for our clients is an important part of our investment strategy, and proactive tax planning can have a dramatic effect on long-term returns. Dowling & Yahnke will monitor pending tax reform proposals and inform our clients of any potential ramifications from future tax legislation. Even though Republicans have majority control of Congress and the White House, tax reform is a drawn-out process and the current proposals will undoubtedly be altered before they are put into effect.

We thank our clients for their continued trust and support. We hope the year is off to a great start and invite you to contact us with any questions or concerns regarding your finances.